Lifetime Pension Vs. Commuted Value

Can I tell you a story? It’s a true one, and – unfortunately – it’s happened more than once. Way more than once. It may even be your story. Here goes:

Sam is leaving his job, and with it his defined benefit plan. He gets a small sheaf of paper from his company, asking him to choose between getting a lifetime monthly pension at retirement, or taking a lump sum now, transferable (at least in part) to a locked in retirement savings plan.

Pension vs. Lump Sum

Over the next few weeks, Sam vacillates between the two choices. The monthly amount seems small compared to the commuted value, and he doesn’t have a lot of faith in management to take care of him for the rest of his life. On the other hand, he’s never paid much attention to investing before, and can’t imagine what he’d do with that much money.

Sixty days is beginning to seem way too short, and with the deadline looming, Sam calls the investment advisor his brother-in-law told him about, figuring that – since he’s a professional – he’ll be able to explain the pros and cons of both options and help Sam weigh them rationally against each other. Plus, he’ll come right to Sam’s house to do it.

The advisor tells Sam to take the lump sum and invest it with him. He has charts that show the growth of an investment over the amount of time Sam has left until he retires, charts that show how much money Sam will be able to withdraw every year based on that growth, and charts that show that the mutual funds he’s recommending have a four or five star rating.

Sam is impressed. Seeing the growth of the lump sum made the lifetime pension seem even smaller by comparison, and being in control of his own retirement money – with the help of his advisor – sounds better than leaving it in the hands of his old company. He decides to take the commuted value.

—

This is where a better storyteller would insert a tidy ending that illustrates how the advisor only cared about earning his commission, and how Sam made a huge mistake that he regretted for the rest of his life.

I can’t write an ending like that because bashing the advisor isn’t the point of my story.

Know Your Options

The point is this: investment advisors exist to sell you investments, not to weigh the relative merits of a lifetime pension vs. a lump sum. There’s no shame in consulting a professional to make the choice between your options, but the right way is to do most of the work yourself, and only then – if you must – seek help, like so:

Step One: Read the paperwork. Every word, more than once. Make notes.
If there’s anything you don’t understand, like how much your surviving spouse would get if you were to pass away before or after you retire, or how much your monthly benefit will increase with inflation – if it will – write down the specific answers you’re looking for.

Step Two: Call HR. Be persistent.
The package always has a phone number on it. The people you speak to don’t know much about how well the pension fund is managed, but they do know the precise details of your entitlement. Ask specific questions and stay on the phone (or make multiple calls) until you know as much as you can.

Step Three: Know what you’re comparing.
Comparing a monthly benefit amount to a lump sum is useless. What you have to calculate is the amount your lump sum will have to grow in order to provide the same monthly benefit without running out before you die. This means the advisor’s job is to talk about probabilities, safe withdrawal rates, and worst-case market returns, as well as the cost to invest, often buried deep in disclosure documents and expressed as a percentage instead of real dollars.

Step Four: Understand the risks.
The risk when you opt for a lifetime pension is that the company paying the pension won’t have enough money to pay you your full entitlement when you retire. The risk when you opt for the commuted value is that your investments won’t perform well enough to provide you with sufficient money to replace the pension for your entire retirement.

There you have it folks. Is it an exhaustive list of questions to consider? No. But it’s a place to start, and a framework that will relegate any advisor you consult to his proper role: information provider instead of salesman.

Sandi Martin is an ex-banker who left the dark side to start Spring Personal Finance, a one woman fee only financial planning practice based in Gravenhurst, Ontario. She and her husband have three kids under five, none of whom are learning the words to “Fidelity Fiduciary Bank” quickly enough. She takes her clients seriously, but not much else.

18 Comments

Rosemary Wells
on August 9, 2013 at 4:51 am

I have been worried that the Nortel situation, where pensioners have had their pensions significantly reduced, may open the doors for other companies to come up with creative ways to avoid paying out the pensions they promised. I noticed you have this identified as a risk. Does anyone know or have concerns about this? How much can we count on our company pensions? Can companies go bankrupt to avoid pension liabilities?

One of the first ways you can check up on your own company pension is to spend some time with Google, looking for the funding status of your particular company plan. The average funded status in Canada right now is about 70%, which means that if the company were to go belly-up today, they have enough in pension assets to pay 70% of their current pension obligations (retirees, and current employees with pension entitlements).

That’s just the first step, of course. You also want to check up on the fund management history and strategy. It starts to encroach a little on crystal ball and tea leaves territory after that, but if a pension (like HOOPP, for instance) is fully funded and has a history of paying non-guaranteed cost of living increases, you should feel fairly confident in the future of your entitlement.

I think you have to compare a defined benefits pension with an annuity (which will pay out much more than just having it as an investment). We had this situation come up before my husband left a company (they were switching to defined contribution but you could be grandfathered as DB). That was a very hard decision, but we decided to go DC since we’d had good results investing ourselves and since DB pensions decrease (normally) with the death of the pensioner and end completely with the death of the spouse. With DC, you have the option of buying an annuity (either with all of the pension or some of it) for higher payouts, but you can also keep money in a RRIF, which isn’t affected by the death of the pensioner (or spouse).

Hope for the best, prepare for the worst. I was lucky to have a DB pension but I always saved to the max in my RRSP also. Lots of sacrifices to do that but I was always thinking about my future as an old woman. As my children left I started saving outside my RRSP also. I have always thought that one stream of income in retirement too scary. Save, save.

Many many moons ago, I took a LIRA instead of leaving the money with my previous employer for a DB pension. Given how the company has done in the interim, I’m not upset with my decision.

The most annoying thing was my PA had been very high when employed there so I couldn’t contribute much to an RRSP, but because I left while still a “young” employee both the LIRA offer and the DB offer were very low. I checked and the amount I received for the LIRA was less than the PAs I had had applied to my RRSP limit for the same time period. It’s frustrating because I can’t get a PA reversal to compensate, so that RRSP room was lost forever AND I won’t get the high pension that the PAs were based on. Sigh.

The time limit to choose between a LIRA and a DB pension should probably be increased. So much is going on during a layoff that former employees are often too stressed to make a good decision.

not advocating one way or another, but for most people this is a great time to consider taking your commuted value if you were to leave as the value is much higher with fixed income being priced the way it is. The main issue like sandi said is the lack of informed decisions.

I like Sandi’s point about Googling your company’s investments and checking up on them. Compare these to the information you are getting on that yearly pension report.

Ah…Saturday morning Google and coffee :)…… Was a life saver when hubby was facing a layoff and we were looking through various health insurances we could get because he was losing his (we had 30 or 60 days to transition to a new plan with no medical questions). We spent a weekend researching Google….

If you’re young, it’s hard to argue that it’s a good idea to take a deferred pension. The Pension Adjustment (PA) formula assume you have a gold-plated 2% Final Average Earnings Pensions plan. By transferring the Commuted Value, you will recover some of your RRSP room back in the form of a Pension Adjustment Reversal if your PA was overstated.

The deferred pension may be a good idea for older workers near retiring. If you’re only 50 years old and want to work a few more years, it’s probably not worth risking a guaranteed payout for life in the markets. We might have another market crash like 2008 and it could take years for you to recover that money.

If you’re young and you have 30+ years to retirement, you have to ask yourself whether your company will still be around in 30 years. Who knows in today’s economy. Also, your deferred pension will be frozen and won’t grow. $200 per month may seem alright in 2013, but by 2043 when milk cost $11.99 for 4 litres it won’t be much. Also, if you decide to retire early, deferred pensions are often reduced at a higher rate than if you were to retire as an employee of the company.

well said Sean. I think many people forget to include the pension payout option in their decision as well. Depending on the future options that they would choose (guaranteed,10yr, 15yr, etc etc.)this could have a huge impact as well

No matter how many times I question option 1 vs option 2, as many times I can’t decide. I’m 64, retiring in June, have a great DB pension, still a mortgage however, due to divorce, but the house is now worth at least 6 times more than the mortgage. I have some RRSP’s but no savings and thought it would be nice to take the commuted value to pay off the mortgage, as approx. half of it can go into a bank account after taxes. This freedom is oh so enchanting but then what? I have to watch my money go up and down in my golden years and possibly cause me severe anxiety and then stroke out. Or, live until it’s all gone and then just sell my house. Why is this such a difficult decision? None of use lives forever!!!

This is a very interesting subject. I am currently debating it myself. I am 50 y.o. and I work for the Gov of Canada and have a DB pension plan that is also indexed. I am expecting retirement at 55 y.o. with 36 years of service done. My DBP will provide me with 70% of my 5 best years income. I expect the DBP to pay ~75K per year.

I am married with no kids. Both working for the Gov of Canada with DB pensions. The house is mortgage free. We have a rental property that is also mortgage free. We have significant savings too, RRSP, and TFSA. We also do not have any consumer debts.

Since the financial seems well under control, I am hoping to retire before 55 (possibly taking 2 years without pay) and defer my DB pension to 55 (to avoid 5% per year age penalties) and use my RRSP and saving to survive for these 2 years; or explore the CV options…

Any words of advice since my employer is the Gov of Canada and their DB plan is quite secure/stable/indexed?